Everybody agrees that, without meaningful job growth, America will not emerge from its current deep economic funk.  There is plenty of debate, however, over what drives that job creation engine in our country. I’ve recently read several interesting reports that touch on parts of the American job growth conundrum but do not tie them together.  Pooling some compelling statistics from these various sources, I believe that the following conclusions are correct and interrelated :

(1) Job growth drives GDP growth;

(2) New company formation drives job growth;

(3) New companies create the vast majority of new jobs after their Initial Public Offerings;

(4) Increased Initial Public Offerings are required to increase job growth;

(5) If the total annual number of Initial Public Offerings (IPO’s) in the U.S. does not exceed 500, which studies show is the level required to support 3% annual U.S. GDP growth, the U.S. will not generate the job growth necessary to rekindle meaningful sustainable GDP growth in the U.S.;

(6) The most efficient fuel for this IPO engine is venture capital.

The evidence:

(i) Startups are responsible for virtually all the new jobs created in the United States since 1977 (Source: Kauffman Foundation)

“The Importance of Startups in Job Creation and Job Destruction bases its findings on the Business Dynamics Statistics (BDS), a U.S. government dataset compiled by the U.S. Census Bureau. The BDS series tracks the annual number of new businesses (startups and new locations) from 1977 to 2005, and defines startups as firms younger than one year old.  The study reveals that, both on average and for all but seven years between 1977 and 2005, existing firms are net job destroyers, losing 1 million jobs net combined per year. By contrast, in their first year, new firms add an average of 3 million jobs.”

(ii) Clearing the backlog in the U.S. Patent Office (USPTO), could create 2.5mm new jobs over the next three years by contributing to startup formation.  Source:  New York Times Opinion article, Inventing Our Way Out of Joblessness by Hank Nothaft and Paul Michel, August 5, 2010 )

“1.2 million patent applications are currently awaiting examination by the USPTO …. each new issued patent creates  between 3 and 10 jobs.  Historic rates of patent grants suggest clearing the backlog could create 2.5mm jobs over the next three years.”

(iii) “Roughly 600,000 new businesses (that employ others) are started each year in the U.S.”  . . .

(iv) “Roughly 1,000 businesses receive their first VC funding each year . . .This means that only 1/16^th of 1% of new businesses obtain VC funding. . . .”

(v) “Since 1999, over 60% of IPOs have been VC-backed.  This is an extraordinary percentage considering that only 1/16^th of 1% of all companies are VC-backed.” “… it is highly unlikely that a company that does not take venture capital ends up going public. … Consistent with this success, venture capital has fueled many of the most successful start-ups of the last thirty years. … Four of the twenty companies with the largest market capitalization in the U.S.—Microsft, Apple, Google, Cisco—have been funded by venture capital.”

Source of (iii), (iv), and (v): “It Ain’t Broke: The Past, Present, and Future of Venture Capital”, by Professor Steven N. Kaplan of the University of Chicago Business School and Professor Josh Lerner of Harvard Business School.

(vi) Going back to the 1970’s it has been documented that 92% of the job growth in venture-backed companies occurs AFTER their IPO:

(vii) IPO’s currently account for 13% or LESS than all liquidity events for venture backed companies, down from 56% during the period from 1992 -2000:

(viii) The current IPO backlog and, more importantly, the poor aftermarket performance for the 85 IPOs priced in 2010 YTD, are symptomatic of a broken IPO pipeline:

According to David Weidner, author of the Wall Street Journal’s MarketBeat Blog, “Dealogic reports that the current 180-day backlog for IPOs now stands at 125 deals, a level three times higher than at the same point last year. The biggest industry waiting is computers and electronics with 23 deals seeking to raise as much as $4.8 billion, followed by finance, 19 deals, and healthcare, 17 deals. Private-equity and venture capital firms have been hard hit too. …While that door hasn’t closed, it has stalled, at least for the 125 issues waiting for the storm clouds to dissipate. So far, it’s been rough-going for most of the issuers who have taken the plunge. Of the 85 IPOs priced so far this year, only 28 are up. The total return for all issues combined is -1.97%, according to IPOScoop.com.”

(ix) The U.S. capital markets for listed equities have been in systemic decline since 1997, while every other major international equity market has been growing.  This is due to systemic regulatory failure and the unintended consequences of ill-conceived regulation that disproportionately negatively impacts startups.

For the detailed study behind (ix) and the two slides above, read “Market Structure Is Causing the IPO Crisis– And More”, by David Weild and Edward Kim, published by Grant Thornton in June 2010.

Conclusion:  If we don’t fix the IPO problem in America, we will not fix the job problem in America.  Venture capital is an essential ingredient to this recipe for success.  I can’t understand why our legislators and policymakers don’t understand this. If they did, there would be no higher legislative priority than promoting regulatory and tax reform to stimulate new capital formation and venture capital in the U.S.  The fact that Singapore, Brazil, India, China, Chile, the U.K., and other countries have figured this out should serve as strong corroborating evidence to the accuracy of this conclusion.

In a Wall Street Journal editorial, Otellini’s Lament, dated August 27,2010, the editor quotes Intel CEO Paul Otellini’s recent comments: “…Otellini . . . warned a technology forum this week that without a change in U.S. government policy ‘thenext big thing will not be invented here.  Jobs will not be created here.  And wealth will not accrue here.  Ultimately, we will face an inevitable erosion and shift of wealth– much like we are witnessing today in Europe.’”

I agree with Mr. Otellini, and it is no coincidence that my first book, Venture Capital: Theory & Practice, which I co-authored with Professor Mannie Manhong Liu of Renmin University of China, is in Chinese and is being published in China in October.  For more on the book, see my next blog post.

I was recently invited to join the Family Business Wiki’s Town Square by founder Don Levitt and have just posted my first contribution, which is titled: How Family Businesses and Venture Capital Backed Companies Face Similar Boardroom Challenges.

The National Venture Capital Association and executive recruiting firm SpencerStuart recently released a white paper, “Emerging Best Practices for Building the Next Generation of Venture-Backed Leadership”.  One of the key points from the paper is the increasing preference by VCs for CEOs who have ‘been there and done that’: When seeking talent for emerging sectors (such as clean technology) with a limited CEO pool, 2010 survey
respondents clearly favored proven venture-backed CEOs from unrelated sectors (58%) over sector entrepreneurs with no CEO experience (31%) or industry leaders from large companies who lack experience in an entrepreneurial environment (11%).

This is also consistent with the challenging, resource constrained environment in which VCs must now operate– it doesn’t make sense to have an inexperienced CEO cutting their teeth on your funds if you can avoid it as the next financing round will be painful– especially if your management team has not executed to meet the company’s board approved operating plan.

The paper makes a number of interesting observations, several of which I summarize below:

* “Vision and fundraising skills are more important than they were a decade ago.”

* “VCs increasingly prefer to find executives who already have a small-company education.”

* “Despite the sea change in the venture capital landscape over the past decade, firms haven’t significantly changed their approach to evaluating senior-level talent.”

*”Firms remain less systematic . . . about conducting formal assessments of their CEOs and top managers after the hire.  Only 25% of respondents to our 2010 survey conduct formal, ongoing management assessments after the investment has been made.”

*”In addition to expecting more of their board members, venture capitalists are also recruiting more independent board members.  Seventy-five percent of 2010 survey respondents said they are recruiting more independent/outside board members now that they face a longer path to liquidity.”

From my fourteen years of experience as a venture capitalist, I can say with conviction that  I have consistently seen the most ill-suited incipient entrepreneurial CEO’s come from large company backgrounds.  When the going gets tough, executives who have grown up in the comfort of the large enterprise typically  are uncomfortable with the difficult actions required to cut significant cost– they tend to be reactive as opposed to proactive about making these changes. Fundamentally, newcomers to VC management who do not have small company experience simply aren’t as self reliant as they need to be to successfully lead a group in a small company.

I was most disappointed to see that venture-backed companies continue to avoid the formal process of reviewing executives after they are hired.  Again, in my experience, I have consistently found that the review process is one of the most important tools for aligning interests between the board and the management team.  We have reaped major benefits from doing this in our portfolio companies, and we have worked with outside organizational consultants to do it.  It is money well spent.

I’ve been associated with the Aspen Institute’s Socrates Society for 14 years and co-chaired the Steering Committee for this program from 2006-2008.  James Beldock, who is both a Socrates Society alumnus and an Aspen Institute Crown Fellow, recently posted on his blog about the important role the Aspen Institute plays in developing strong leaders.

In his post, James draws a parallel between private sector CEO leadership qualities evident in comments made by Aspen Institute Rodel Fellow, Atlanta Mayor Kasim Reed, and D.C. Public Schools Chancellor Michelle Rhee as they discussed how they approached significant challenges:

Mayor Reed, a Rodel Fellow of the Institute, and Chancellor Rhee spoke candidly about the leadership challenges they face.  When asked by David Gergen (who doesn’t know how to ask an easy question) how he handled the structurally unsound pension liability that he faced literally within weeks of stepping into the Atlanta mayor’s office, Mayor Reed provided the evening’s most clear moment of “cross-fertilization.”  He put his CEO hat on and described the meetings he had with union leaders in which he explained the financial realities—just as a CEO must when he must change benefits or even adjust the size of his workforce.  Especially in today’s age of tight budgets and high unemployment, financial pragmatism may not be popular, but it affords a serious public leader a unique opportunity:  to make difficult decisions which result in long-term benefits, even if they attract short-term criticism.

To read the full post, click HERE.

This is the sixth in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: You had some thoughts about contract terms. Do you think the trend is shifting in favor of institutional LPs to receive better terms?

Answer: Certainly as the sources of capital have become more  selective and scarce, the GPs have had to become more aware of LP concerns over terms. While  the GPs in top tier funds will still be able to maintain favorable terms (and  LPs will always want to get into their funds), even these GPs have made some  concessions to maintain a supportive investor base. For example, recent press  reports have indicated that at least two prominent funds had lowered their  ”premium” carry structures, and made the payment of a 30% carry rate subject  to the return of a multiple of the investors’ capital. For those other funds  that are not oversubscribed, there will undoubtedly be some pressure on  terms. Though there has been a lot of talk about the terms suggested in the  recent guidelines published by the ILPA, these guidelines have not fully  caught hold (and some proposed terms –like joint and several liability  on clawbacks — may be seen as too extreme). Still, in the current fundraising  environment, there will certainly be some movement to provide an  alignment of interests between LPs and GPs, while trying to maintain the  appropriate incentives for the GPs.

This is the fifth in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: Please differentiate between the governance of a VC fund versus the governance of companies in a VC fund’s portfolio? Is one more important than the other?

Answer: This is a very important question, and it starts with recognizing that VC funds, as partnerships, are governed very differently from portfolio companies, which are corporations.  The VC fund may have one managing partner that sets the tone and controls the entire firm, or it may have a collegial distribution of governance among several senior partners.  The best way to understand how a VC fund is governed begins with an analysis of the fund’s investment committee, its deal due diligence process, and the specific allocation of the fund’s investment capital among the individual partners.  An important question to ask is, do the partners evaluate themselves and each other on an annual basis or at all? You might be surprised to learn that many VC funds lack an internal feedback loop, that the partners may not communicate openly among each other, and that the partners themselves may lack a formal measure of accountability among each other, even though the economics are divided formally in the management company agreement.

Turning to portfolio companies, the board of directors is responsible for the governance of the company, and here we have a very interesting dynamic which often leads to board dysfunction—the VC directors have inherent conflicts of interest as representatives of their funds and as fiduciaries who must act in the best interests of all of the shareholders.  In addition there is a major tension and conflict between the management team and the VC directors—the management wants more share ownership, and the common equity is at the bottom of the seniority stack behind the various series of preferred equity rounds.  The VCs want capital efficiency, which means they want management to do more with less.  Compounding the complexity is the fact that most VC-backed companies replace their CEOs twice between the founding and the liquidity event.  So you can imagine that the VC boardroom governance equation is very complex and rife with opportunities for problems.

This is the third in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: Given recent instances of VC-backed company fraud and questions about the management team, how can institutional investors protect themselves from key person risk?

Answer: You are asking a fundamental question here about trust, which relates to your prior question.  I could restate your question by saying, how do I know that I’ve backed someone as a GP who is trustworthy?  The answer is, you have to do your homework on that person, which means that you have to make a full range of reference calls to people who are not on the person’s reference list.  This takes resources and time.  If you are not equipped with the resources to do the work, then you need to rely on someone else’s process—but again that has to be an independent third party whose due diligence credentials are also trustworthy.

Let me turn the table on you a little bit because I sit in your shoes all the time– as a venture capitalist who bets on entrepreneurs, my greatest challenge is to sit across the table from a very enthusiastic person and judge their credibility—will they actually do what they say they are going to do?  Will they work 24/7 to get the job done?  How will they behave when unforeseen challenges occur—which they always do?  Institutional investors have to do the same thing because they are betting on people, and they need to establish a considerable measure of trust if they are going to sign on to a 10 year commitment to invest in illiquid assets.  This is the toughest part of our jobs—as I look back over my the 14 years I have spent in venture capital as part of my 29 year finance career, the biggest mistakes I have made have always been related to key person risk, as opposed to picking the “wrong” technology.

It’s that time of the year again– time to send out audited financial statements and K-1’s to your limited partners– which means it’s also a great time to address some of the common questions that investors raise about VC partnership governance and disclosure issues.

I recently spent some time answering a series of such questions posed to me by Susan Mangiero, the founder and CEO of Investment Governance, Inc., whose site Fiduciary X, is an emerging “one-stop best practices information portal for investment decision-makers and their service providers.” Fiduciary X, on whose advisory board I serve, combines peer networking, research, productivity tools, proprietary data sets,  and a governance-focused knowledge base with a documents archive to serve fiduciaries and risk managers.

In the interests of sharing this interview with a broad group of interested readers, I am going to be posting one question and my answer each day for ten days, including today.  For access to the full interview, which will be published March 15, please go to the Fiduciary X Ezine registration site.

Question:  How much information are limited partners (pensions, endowments, foundations, etc.) entitled to receive from a VC fund?

Answer: Section 17-305 (b) of the Delaware Revised Uniform Limited Partnership Act, which governs LP information rights according to DE law, specifically allows the GP to withhold from LPs “any information the GP reasonably believes to be in the nature of trade secrets or other information the disclosure of which the GP in good faith believes is not in the best interest of the Fund or could damage the Fund or its business or which the Fund is required by law or by agreement with a third party to keep confidential.”  This would include the GP’s fiduciary duties and confidentiality obligations with respect to not disclosing portfolio company information without the consent of such company.  The Act provides for a specific list of information that LPs are entitled to, and funds historically disclose that same information to their LPs—the top law firms in Silicon Valley model their LP agreement forms to be pretty consistent with Delaware law.

Specifically, Section 17-305 of the Act provides for the following:

(a) Each limited partner has the right, subject to such reasonable standards (including standards governing what information and documents are to be furnished, at what time and location and at whose expense) as may be set forth in the partnership agreement or otherwise established by the general partners, to obtain from the general partners from time to time upon reasonable demand for any purpose reasonably related to the limited partner’s interest as a limited partner:

(1) True and full information regarding the status of the business and financial condition of the limited partnership;

(2) Promptly after becoming available, a copy of the limited partnership’s federal, state and local income tax returns for each year;

(3) A current list of the name and last known business, residence or mailing address of each partner;

(4) A copy of any written partnership agreement and certificate of limited partnership and all amendments thereto, together with executed copies of any written powers of attorney pursuant to which the partnership agreement and any certificate and all amendments thereto have been executed;

(5) True and full information regarding the amount of cash and a description and statement of the agreed value of any other property or services contributed by each partner and which each partner has agreed to contribute in the future and the date on which each became a partner; and

(6) Other information regarding the affairs of the limited partnership as is just and reasonable.

The current state of the art for Agreements of Limited Partnership in venture capital allows the GP to override the information rights LPs have pursuant to the Delaware Revised Uniform Limited Partnership Act (the “Act”) as permitted pursuant to the Act and allows the GP to “adjust” identifying information given to the LPs in order to protect the identity of the Fund’s portfolio companies, which often is an issue in the case of Freedom of Information Act (FOIA) LPs.  In addition, the partnership agreement allows the GP to restrict / withhold information from LPs if “the General Partner reasonably determines [such LP] cannot or will not adequately protect against the [improper] disclosure of confidential information, the disclosure of such information to a non-Partner likely would have a material adverse effect upon the Partnership, a Partner, or a Portfolio Company.”  Other elements of the well drafted agreement do provide the LP’s with disclosure rights to their advisors, equity holders, etc. and provide remedies and protections to the GP with respect to GP withholding rights and improper LP information disclosure.

I recently chaired a panel at the Stevens Institute of Technology cybersecurity conference in Washington D.C. and was asked by the conference organizers to develop an agenda based on a review of pending Senate Bill 773, the “Cybersecurity Act of 2009″.  Our panel, which included two security experts– former National Security Agency Deputy Director Bill Crowell and Ted Schlein of KPCB, focused on some of the challenges to the passage of effective legislative solutions aimed at securing data on the Internet. The point of departure for our panel was a consideration of two specific sections of Senate Bill 773.

The summary of the Bill’s purpose highlights the importance of the continued free flow of commerce, the need for secure cyber communications on the Internet, and a defensive approach to prevent disruption to these activities.

Three focal themes emerged from the discussion:

I That the implementation of effective international standards of cooperation to achieve cybersecurity is going to be more difficult to achieve and is far more complex than it appears. Google’s unfolding experience in China is only the latest manifestation of the complexity of this issue.

II That developing a new legislative protocol for the dissemination of cybersecurity threat information to the public is going to be very difficult and is likely to lead to unintended consequences.  While one government organization may be designated as responsible for this delicate role, many others will continue to lay claim to ultimate authority over what is or is not classified information in the cyber realm.

III That legislative approaches to cybersecurity need to more fully recognize that promoting healthy and robust U.S. capital markets is essential to our nation’s economic and national security.

The globally integrative power of the Internet brings with it major challenges when it comes to international cooperation.  This is especially the case when the economic competition between nation states is increasing and different players approach the same playing  field with completely different rules as to what constitutes fair play. Bill 773 designates the President to develop norms, organizations, and other cooperative activities for international engagement to improve cybersecurity.

What do we mean by different approaches to economic competition? McAfee recently released its fifth annual Virtual Criminology Report, concluding that politically motivated cyber attacks have increased in a number of countries, including the United States. There is a clear tension between the desire and need for international cooperation and setting standards in cybersecurity and the reality that cyber attacks are now a tool of governments.

Bill Crowell was quoted in that report as saying that “Over the next 20 to 30 years, cyber-attacks will increasingly become a component of war,” “What I can’t foresee is whether networks will be so pervasive and unprotected that cyber war operations will stand alone.”

In section 14, Bill 773 designates the Department of Commerce as the clearinghouse of cybersecurity threat and vulnerability information to the Federal government and the Private sector.  The protection of our nation’s critical infrastructure is a matter of both economic and national security.  This is also probably one of the most sensitive “political turf” battle issues in the United States.  The Department of Defense, the NSA, various military branches, and the intelligence community all lay claim in various ways to a piece of the cybersecurity pie. Nobody will argue that a breach of our nation’s cybersecurity impacts commerce.  Can you explain why the Department of Commerce has been designated to serve as the clearinghouse of cybersecurity threat and vulnerability information to Federal Government and private sector owned critical infrastructure information systems and networks, and how do you believe this is actually going to work in terms of coordinating with the military?  What happens when someone invokes making threat data classified as a matter of national security—aren’t we already living in ignorance of a lot of threat information precisely because of this problem?

Click here for a link to the full panel broadcast, which was broadcast on C-Span.

Startups, the engine of American innovation and an important source of job growth nationally, took a severe beating in 2009 because so few were funded by the venture community. While the freedom to fail remains a given among emerging companies, a creeping risk aversion among investors inhibiting new capital formation for long-term, illiquid investments threatens an entire generation of American entrepreneurs.

This should be particularly unnerving to our elected representatives because strong startups have proven their ability to grow rapidly and produce jobs, particularly if they go public. Public companies such as Google, Cisco and Intel, all initially venture-backed, today represent 17 percent of U.S. gross domestic product and have created a total of more than 12 million good jobs. The most important startup centers are Silicon Valley, metropolitan Boston, Seattle and Austin and, increasingly, northern Virginia.

Many venture capitalists and other capital markets experts believe that 2010 will be a better year for achieving IPO liquidity because a number of well established companies that remain private have reached sufficient scale to attract much-needed public equity funding. But this is a small minority of the venture-backed universe, and the majority of fledgling technology companies continue to face existential challenges. A significant but largely unheralded problem for many is that they are managed poorly at the highest levels, and this lack of stewardship can lead to a company’s demise.

About two-thirds of CEOs who initially take the top job at a startup are eventually replaced, but many venture capitalists approach the likelihood of management change as an afterthought, even though driving an orderly process for management succession represents the venture capitalist’s most important role as a corporate director. Much of the explanation for this surprisingly common problem can be traced to misaligned interests between the board and the CEO, a situationthat is only aggravated by stressful economic times.

While most startups experience CEO change as they evolve into a self-sustaining company, venture capitalists who sidestep the process associated with this managing reality set the stage for operational turmoil and key personnel defections.

I believe venture capitalists and CEOs must put their differences aside so that these startups can survive and ultimately thrive. Among the reasons for the differences of approach to managing CEO change among venture investors is that early-stage players often forge a strong personal, as well as business relationship, with the CEO. This relationship is often absent among later-round venture investors. And the issue of equity dilution, always high on the CEO’s agenda, often clashes with the agenda of all venture backers. Things get even hotter when a startup fails to meet projections, requiring more capital than originally anticipated, an all-too-common scenario today.

Many founders find it particularly galling to be found wanting in their management skills at precisely the time that their fledgling companies experience rapid revenue growth and markedly improved performance. The sweat they have poured into the research and development phase is the foundation for the company’s budding success. Many founding executives view the situation as one of betrayal by their venture backers, sparking the collateral damage mentioned above.

Much can be accomplished to mitigate these stresses if startup boards and CEOs become more transparent and put sound management strategies into place.

It isn’t particularly difficult to turn this situation around. Venture capitalists need to take a proactive approach and manage toward the reasonable expectation of CEO change from day one. This means engaging CEOs in a frank discussion of their strengths and weaknesses, constantly assessing CEO performance, and forging a relationship with the CEO-founder that can transcend a management change. This creates a win-win for both parties. The outcome could be a new role for the founder, preserving his ability to make a productive contribution to the company.

Venture capitalists also must stop ignoring clear early-warning signs that the time has come to replace the CEO.

Here are five common early warning signs of trouble in the corner office:

• A CEO does not react constructively to board member suggestions, is increasingly inflexible in considering strategic board changes, or stubbornly clings to a plan that is not working.
• Significant company problems are obvious but the CEO goes into denial, sometimes by seeking seats on outside boards, scheduling frequent vacations, or getting involved in political, community or charitable endeavors. A CEO often missing-in-action because of these activities has usually lost the requisite “fire in the belly” that a venture-backed startup CEO needs.
• The CEO cuts off the flow of information to the board and typically initiates few calls to board members. Typically, every director should hear from a CEO in advance of board meetings, as well as once or twice a month to celebrate good news, discuss a setback, or simply discuss a basic management issue.
• A CEO increasingly pleads ignorance of a problem, complaining that other executives did not keep him informed. But the CEO doesn’t present a clear case and a plan to remedy the situation or tries to toss problems back in the board’s lap.
• A CEO starts referring inquiries from board members to other executives as a loyalty test, putting out the word that no executive is to communicate with a board member without first getting approval from him. It’s a red flag when subordinate executives give board members scripted, vague answers in response to questions.

Venture capitalists and other members of startup boards must become much more involved in their assessment of the company’s long-range strategy. To do this, they have to first learn to work better together through more frequent communication, both in and out of the boardroom. They must master the art of compromise in the boardroom and focus on the real goal – maximizing the odds of success of their startups. This is imperative for America as startups and venture capitalists begin a new and pivotal year.